What I say unto you I say unto all, watch. Mark 13:37

August 09, 2011

Global Economic Downturn: A Crisis of Political Economy

Classical political economists like Adam Smith or David
Ricardo never used the term “economy” by itself. They always used the term
“political economy.” For classical economists, it was impossible to understand
politics without economics or economics without politics. The two fields are
certainly different but they are also intimately linked. The use of the term
“economy” by itself did not begin until the late 19th century. Smith understood
that while an efficient market would emerge from individual choices, those
choices were framed by the political system in which they were made, just as the
political system was shaped by economic realities. For classical economists, the
political and economic systems were intertwined, each dependent on the other for
its existence.

The
current economic crisis is best understood as a crisis of political economy.
Moreover, it has to be understood as a global crisis enveloping the United
States, Europe and China that has different details but one overriding theme:
the relationship between the political order and economic life. On a global
scale, or at least for most of the world’s major economies, there is a crisis of
political economy. Let’s consider how it evolved.

Origin of the Crisis

As we all know, the origin of the current financial crisis
was the
subprime mortgage meltdown in the United States. To be more precise, it
originated in a financial system generating paper assets whose value depended on
the price of housing. It assumed that the price of homes would always rise and,
at the very least, if the price fluctuated the value of the paper could still be
determined. Neither proved to be true. The price of housing declined and, worse,
the value of the paper assets became indeterminate. This placed the entire
American financial system in a state of gridlock and
the crisis spilled over into Europe, where many financial institutions had
purchased the paper as well.

From the standpoint of economics, this was essentially a
financial crisis: who made or lost money and how much. From the standpoint of
political economy it raised a different question: the legitimacy of the
financial elite. Think of a national system as a series of subsystems —
political, economic, military and so on. Then think of the economic system as
being divisible into subsystems — various corporate verticals with their own
elites, with one of the verticals being the financial system. Obviously, this
oversimplifies the situation, but I’m doing that to make a point. One of the
systems, the financial system, failed, and this failure was due to decisions
made by the financial elite. This created a massive political problem centered
not so much on confidence in any particular financial instrument but on the
competence and honesty of the financial elite itself. A sense emerged that the
financial elite was either stupid or dishonest or both. The idea was that the
financial elite had violated all principles of fiduciary, social and moral
responsibility in seeking its own personal gain at the expense of society as a
whole.

Fair or not, this perception created a massive political
crisis. This was the true systemic crisis, compared to which the crisis of the
financial institutions was trivial. The question was whether the political
system was capable not merely of fixing the crisis but also of holding the
perpetrators responsible. Alternatively, if the financial crisis did not involve
criminality, how could the political system not have created laws to render such
actions criminal? Was the political elite in collusion with the financial elite?

There was a crisis of confidence in the financial system and
a crisis of confidence in the political system. The U.S. government’s actions in
September 2008 were designed first to deal with the failures of the financial
system. Many expected this would be followed by dealing with the failures of the
financial elite, but this is perceived not to have happened. Indeed, the
perception is that having spent large sums of money to stabilize the financial
system, the political elite allowed the financial elite to manage the system to
its benefit.

This generated the second crisis — the crisis of the
political elite. The Tea Party movement emerged in part as critics of the
political elite, focusing on the measures taken to stabilize the system and
arguing that it had created a new financial crisis, this time in excessive
sovereign debt. The Tea Party’s perception was extreme, but the idea was that
the political elite had solved the financial problem both by generating massive
debt and by accumulating excessive state power. Its argument was that the
political elite used the financial crisis to dramatically increase the power of
the state (health care reform was the poster child for this) while mismanaging
the financial system through excessive sovereign debt.

The Crisis in Europe

The sovereign debt question also created both a
financial crisis and then a political crisis in Europe. While the American
financial crisis certainly affected Europe, the European political crisis was
deepened by the resulting recession. There had long been a minority in Europe
who felt that the European Union had been constructed either to support the
financial elite at the expense of the broader population or to strengthen
Northern Europe, particularly France and Germany, at the expense of the
periphery — or both. What had been a minority view was strengthened by the
recession.

The European crisis paralleled the American crisis in that
financial institutions were bailed out. But the deeper crisis was that
Europe did not act as a single unit to deal with all European banks but
instead worked on a national basis, with each nation focused on its own banks
and the European Central Bank seeming to favor Northern Europe in general and
Germany in particular. This became the theme particularly when the recession
generated disproportionate crises in peripheral countries like Greece.

There are two narratives to the story. One is the German
version, which has become the common explanation. It holds that Greece wound up
in a sovereign debt crisis because of the irresponsibility of the Greek
government in maintaining social welfare programs in excess of what it could
fund, and now the Greeks were expecting others, particularly the Germans, to
bail them out.

The Greek narrative, which is less noted, was that
the Germans rigged the European Union in their favor. Germany is the world’s
third-largest exporter, after China and the United States (and closing rapidly
on the No. 2 spot). By forming a free trade zone, the Germans created captive
markets for their goods. During the prosperity of the first 20 years or so, this
was hidden beneath general growth. But once a crisis hit, the inability of
Greece to devalue its money — which, as the euro, was controlled by the European
Central Bank — and the ability of Germany to continue exporting without any
ability of Greece to control those exports exacerbated Greece’s recession,
leading to a sovereign debt crisis. Moreover, the regulations generated by
Brussels so enhanced the German position that Greece was helpless.

Which narrative is true is not the point. The point is that
Europe is facing two political crises generated by economics. One crisis is
similar to the American one, which is the belief that Europe’s political elite
protected the financial elite. The other is a distinctly European one, a
regional crisis in which
parts of Europe have come to distrust each other rather vocally. This could
become an existential crisis for the European Union.

The Crisis in China

The American and European crises struck hard at China, which,
as the world’s largest export economy, is a hostage to external demand,
particularly from the United States and Europe. When the United States and
Europe went into recession, the Chinese government faced an unemployment crisis.
If factories closed, workers would be unemployed, and unemployment in China
could lead to massive social instability. The Chinese government had two
responses. The first was to keep factories going by encouraging price reductions
to the point where profit margins on exports evaporated. The second was to
provide unprecedented amounts of credit to enterprises facing default on debts
in order to keep them in business.

The strategy worked, of course, but only
at the cost of substantial inflation. This led to a second crisis, where
workers faced the contraction of already small incomes. The response was to
increase incomes, which in turn increased the cost of goods exported once again,
making China’s wage rates less competitive, for example, than Mexico’s.

China had previously encouraged entrepreneurs. This was easy
when Europe and the United States were booming. Now, the rational move by
entrepreneurs was to go offshore or lay off workers, or both. The Chinese
government couldn’t afford this, so it began to intrude more and more into the
economy. The political elite sought to stabilize the situation — and their own
positions — by increasing controls on the financial and other corporate elites.

In different ways, that is what happened in all three places
— the United States, Europe and China — at least as first steps. In the United
States, the first impulse was to regulate the financial sector, stimulate the
economy and increase control over sectors of the economy. In Europe, where there
were already substantial controls over the economy, the political elite started
to parse how those controls would work and who would benefit more. In China,
where the political elite always retained implicit power over the economy, that
power was increased. In all three cases, the first impulse was to use political
controls.

In all three, this generated resistance. In the United
States, the Tea Party was simply the most active and effective manifestation of
that resistance. It went beyond them. In Europe, the resistance came from
anti-Europeanists (and anti-immigration forces that blamed the European Union’s
open border policies for uncontrolled immigration). It also came from political
elites of countries like Ireland who were confronting the political elites of
other countries. In China, the resistance has come from those being hurt by
inflation, both consumers and business interests whose exports are less
competitive and profitable.

Not every significant economy is caught in this crisis.
Russia went through this crisis years ago and had already tilted toward the
political elite’s control over the economy. Brazil and India have not
experienced the extremes of China, but then they haven’t had the extreme growth
rates of China. But when the United States, Europe and China go into a crisis of
this sort, it can reasonably be said that the center of gravity of the world’s
economy and most of its military power is in crisis. It is not a trivial moment.

Crisis does not mean collapse. The United States has
substantial political legitimacy to draw on. Europe has less but its constituent
nations are strong.
China’s Communist Party is a formidable entity but it is no longer dealing
with a financial crisis. It is dealing with a political crisis over the manner
in which the political elite has managed the financial crisis. It is this
political crisis that is most dangerous, because as the political elite weakens
it loses the ability to manage and control other elites.

It is vital to understand that this is not an ideological
challenge. Left-wingers opposing globalization and right-wingers opposing
immigration are engaged in the same process — challenging the legitimacy of the
elites. Nor is it simply a class issue. The challenge emanates from many areas.
The challengers are not yet the majority, but they are not so far away from it
as to be discounted. The real problem is that, while the challenge to the elites
goes on, the profound differences in the challengers make an alternative
political elite difficult to imagine.

The Crisis of Legitimacy

This, then, is the third crisis that can emerge: that the
elites become delegitimized and all that there is to replace them is a deeply
divided and hostile force, united in hostility to the elites but without any
coherent ideology of its own. In the United States this would lead to paralysis.
In Europe it would lead to a devolution to the nation-state. In China it would
lead to regional fragmentation and conflict.

These are all extreme outcomes and there are many arrestors.
But we cannot understand what is going on without understanding two things. The
first is that the political economic crisis, if not global, is at least
widespread, and uprisings elsewhere have their own roots but are linked in some
ways to this crisis. The second is that the crisis is an economic problem that
has triggered a political problem, which in turn is making the economic problem
worse.

The followers of Adam Smith may believe in an autonomous
economic sphere disengaged from politics, but Adam Smith was far more subtle.
That’s why he called his greatest book the Wealth of Nations. It was about
wealth, but it was also about nations. It was a work of political economy that
teaches us a great deal about the moment we are in. †